Fixed and Variable Annuities and Their Taxation

I. Introduction

Everyone over age 60 has a nagging fear they will run out of money."—Peter Drucker

"An annuity is an amount payable yearly or at other regular intervals for a certain or uncertain period."—Dictionary definition.

A. The Need for Savings and Investment

1. Society can’t afford to take care of you.

2. Life expectancy has increased from 47 years to 77 years in this century.

3. Annuitants live longer.

Few people annuitized during the long era of exceptionally high interest rates of the ‘70s, ‘80s, and ‘90s. They could live on the relatively generous interest earnings alone. However, there is a chance that interest rates could precess back to their longer-term historic norms of about 5.5%, which could cause some people to dip into principal and worry more about running out of money. Annuitization could become popular again, and insurance companies are working hard to make annuitization more attractive.

4. Persistent inflation

Do you know anyone who retired on about $35,000 in 1963? During that person’s retirement years (1963 to 1993), inflation averaged 5.32%. The purchasing power of their comfortable $35,000 diminished to $7,392. Eighty percent of their purchasing power has been stolen by inflation. They would need $165,000 now to match their 1963 standard of living. People are not saving and investing enough, and they are not protecting their "capital wheels" from taxation and litigation enough. Annuities can help them do both.

B. The Appeal of Annuities

1. Safety of principal

2. Tax benefits

a. Interest (earnings) on principal

b. Interest (earnings) on the interest (earnings)

c. Interest (earnings) on the money that would otherwise be paid in taxes

3. Yield

4. Creditor protection to some degree in some states

C. Typical Buyer (1994 study by The Committee of Annuity Insurers)

1. Over age 50

2. Income $40,000 to $80,000

3. CD alternative buyer

D. Defining Annuity Types

The term annuity includes all periodic payments resulting from the systematic liquidation of a principal sum.

An annuity is a written contract between an annuity contract owner, an annuitant, and an insurance company. Frequently, the contract owner and the annuitant will be the same individual.

Most people think of an annuity as a retirement plan or a series of steady, level payments for life, or a way to receive monthly income from a pension plan. A lump sum of money is paid out as a constant monthly income with the assurance that the payments will continue for the rest of the annuitant’s life. In the "payout mode," an annuitant can protect against the risk of running out of income during life. The economic risk of living too long, a very serious concern with today’s longevity, is protected by the lifetime assurance of income.

Annuities can, in their payment mode, do all of the above.

The owner has all rights in the contract, names the annuitant, and designates and can change the beneficiary. All taxation flows to the owner, and any tax penalties are based on the owner’s age. Although the owner could be a business entity, a trust, or a natural person, only the natural person can enjoy the tax-deferred inside build-up in an annuity. The death of the owner will cause a taxable distribution of the annuity to the beneficiary and, if the annuitant is still alive, surrender charges may apply if the funds are removed from the insurance company.

Most often the owner and annuitant are one and the same, and the direction of the funds is presumably as the deceased wanted it. However, we could run into problems if there are three different individuals involved with one annuity contract, such as could happen if a parent wanted to use a child as the annuitant in an effort to make the tax-deferral continue for a longer life expectancy. In this case, primary and secondary beneficiary provisions should be considered carefully because the death of either the owner or annuitant causes the proceeds to be distributed to the beneficiary.

2. Joint ownership issues

3. Trust ownership issues

An annuity contract held by a trust or other entity as agent for a natural person is considered to be held by a natural person. IRC Sec. 72(u)(l)…beneficial owner is a natural person, we should be OK.

4. Annuitant

The annuitant is the one on whose life the insurance company bases the annuitized payments and must be a living person. The death of the annuitant also causes a taxable distribution to the beneficiary and, if the beneficiary is other than the owner, possibly a taxable gift from the owner to the beneficiary. An annuitization of the contract based on the life expectancy of the annuitant is taxable to the owner.

5. Beneficiary

The beneficiary receives the annuity benefits in the event of the death of the owner or the annuitant and can be a person, business entity or trust and will be responsible for the tax liability.

II. Immediate Annuities—"Payout Vehicles"—Design Characteristics

The purpose of purchasing an immediate annuity is to protect the annuitant against the risk of running out of income during life or, alternatively, to ensure a series of payments for a fixed period of time or in a fixed amount. The first decision you have to make when purchasing an immediate annuity is the choice between a fixed annuity or a variable annuity.

A. Fixed Immediate Annuities

1. Payout guarantees

a. Installment payment—fixed amount

You dictate the amount, the insurance company tells you how long it will be paid whether you live or die.

b. Installment payment—fixed period

You dictate the period of time for the periodic payments, and the insurance company tells you the amount that they can pay based on your age, the interest they will pay you, and the length of time chosen. The period choosen could be a little as two months or as long as you desire (payments must satisfy the insurance company’s minimum payment rules, e.g., no less than $20 per payment). Payments continue for the fixed period whether you live or die.

You may direct the insurance company to make payments of fixed specific dollar amounts at equal intervals until both principal and interest are exhausted or, alternatively, for a fixed period of time. The time chosen would determine the amount of each payment. These annuities are useful in situations where there is an income tax liability on the payments. You can spread the tax liability over a period of years convenient for the annuitant.

Also, you can purchase such contracts to fund for a specific purpose (for example, an annuity payment commencing when a parent enters a nursing home) to ensure payments for a specified period.

Whenever funds are needed to provide for a specific need, an annuity can be designed to provide those funds. There is one caution that we must observe. The Tax Reform Act of 1986 imposed a 10% penalty tax on any annuity distributions to an annuitant prior to age 59-1/2 that are not based on life contingencies. Fixed period and fixed installments are not life contingent annuities.

c. Life annuity (straight life/pure annuity)

Your specified income continues until your death. (Risk: receive one month’s payment, die, payments terminate)

d. Life and period certain (10 or 20 years)

The payments are to continue for your life; however, you may wish to ensure that someone other than the insurance company benefits if you die early. The insurance company is instructed to make the payments to your named beneficiary for the remainder of the guarantee period, at least 10 or 20 years, even if you die before that time.

e. Life and refund certain

In this case, you again are trying to protect against the early termination of payments due to the fact that your death occurs prior to receiving at least your principal back from the insurance company. The company is instructed to pay for your life, but should your death occur early, it refunds your deposit by continuing monthly payments to your named beneficiary until the amount of deposit is returned. If it is a cash refund, the payout will be the discounted present value of the future payments.

f. Joint and survivor life annuity

The annuity pays for the whole of the lives of two individuals. It continues to pay level payments until the death of the last to die of the two annuitants. Variations of this form of payout is a joint and 75% survivor annuity, which indicates that the surviving annuitant will receive 75% of the original monthly payment, or joint and 50% survivor annuity.

g. Joint and survivor life annuity with period certain

This is to protect against the early termination of payments if both of the annuitants die early. The insurance is instructed to continue payments until the death of the last to die, with a minimum payout period of at least 10 or 20 years.

h. Joint and survivor life annuity with refund certain

This protects against the early termination of payments due to the death of both annuitants. The insurance company is instructed to refund the remaining balance of your deposit by continuing monthly payments to the named beneficiary after the death of both annuitants until the amount deposited is returned or, if it is to be a cash refund, to pay out the discounted present value of the remaining payments.

2. Cost comparisons among types

The decision-making process in selecting among the life annuity alternatives starts with a question to the insurance company: "I want a $1,000 check every month for the rest of my life. I am 65. What will such a contract cost me, and what alternatives are available to me?"

A life annuity costs the least. In other words, this type of annuity will provide the largest possible monthly payment based on a given deposit into the contract. It is low in cost because of the high risk of the loss of capital. The risk in a life annuity is that if you die prior to the time the deposit in the annuity has been used up, the balance of the deposit and the interest on the capital is lost, forfeited to the insurance company. Your death terminates the income and the balance of the principle is retained by the insurance company or pension plan. This would occur even if only one monthly check had been paid prior to your death. Most buyers of annuities consider this too great a risk. They want greater safety and assurance that the payout stream will continue to their beneficiary in the event of their death.

Fall 1993 Rates

This is one method of ensuring the continuation of the payout stream in the event of the primary annuitant’s death. Under this election, you would purchase a guarantee of payments of some minimum time period, such as 10 or 20 years. In the table below, you will note that this guarantee increases the purchase price of the annuity by about 6% for a 10-year minimum guarantee and about 22% for a 20-year guarantee. The purchaser is buying insurance that costs $8,830 ($152,655–143,825 = $8,830) in order to ensure that payments will continue for at least 10 years, and $31,830 ($175,655–143,825 = $31,830) in order to ensure that payments will continue for 20 years.

b. Life and refund certain annuity

Under this alternative, you elect to receive a life income. However, if you don’t live long enough to receive all of the principal, it will be refunded to your named beneficiary in continued monthly installments or in a cash settlement (discounted present value of the payments due).

c. Joint and survivorship life annuity

The joint and survivorship life annuity is to function as an ensured payout vehicle during the lives of two people. It is to continue the level monthly payments through the life of the last to die. It normally is used by married couples for pension income to ensure that the income stream will not terminate at the death of the first annuitant.

Under the joint and survivorship annuity option, there also are a number of alternatives. The refund certain or a period certain guarantee could be selected for 10 or 20 years. You may adjust the continued payments to the surviving annuitant to be consistent with the survivor’s needs. During both the annuitants’ lives, the income will be one amount, but after the death of the first, that income could be reduced to 75%, 66.6%, or 50% of the amount of the original payment. Such an election reduces the cost for the income guaranteed. For instance, in order to ensure $1,000 level payments for both lives, it costs $188,421.

Fall 1993 Rates

However, from a practical standpoint, you may purchase an annuity because you cannot afford to live on the interest earnings alone of your $100,000 of capital. You may be fearful of investing aggressively in order to earn higher yields for fear of losing your capital during your lifetime. It may be very comforting to seek the shelter of an annuity, which promises an income stream that cannot terminate during your lifetime. Your security would be in a constant stream of freely usable income, rather than capital sitting in a bank.

As you review the net after-tax spendable income from the investment of $100,000, you may have one of two reactions. You may think that it ensures you a pretty good income for the rest of your life; or you may think that you could generate that much income today with $100,000 in some other investment. Your reaction will be based upon the current interest rates. In an economic environment in which prevailing short-term interest rates are relatively high, you are not likely to find the annuity principle very appealing. Also, the younger you are, the less appealing it will be. However, in an economic environment in which prevailing interest rates are fairly low, they may look pretty good to you. The reason for this is that when an insurance company guarantees a fixed income for the life of an annuitant, they are looking at a long-term obligation that must be conservatively met with long-term investments.

In short, the insurance company must forecast prevailing interest rates available for this block of capital (your investment) for the rest of your life. They will do so in a conservative fashion, and they are likely to use long-term bonds and mortgages as a reserve for the annuity liability, i.e., their obligation to pay you.

d. Obtaining annuity quotes

Insurance company annuity rates are competitive and constantly changing. The rates shown in the table are based on the prevailing rates effective October 1993. You would be wise to shop carefully for your annuities and to look not only for a competitive rate, but also for a quality company that can be expected to perform well for the rest of your life. You probably would not even consider an immediate payout life annuity unless you expected to live a long time, so company selection is very important—that company’s future performance will have to be good. There are people out there who did not heed this warning and have had their life income payments interrupted at best and lost at worst because of insurance company failures. Remember, once a contract is annuitized (i.e., payments have commenced), there is no turning back; there are no 1035 exchanges, you are dependent on the company you have chosen. When your employer terminates a retirement plan and funds your benefits by buying an immediate payout annuity, the insurance company risk is being transferred to you. Make sure you have some say in where the employer buys your annuity contract. If you would like to find out what income may be available to you, you may obtain quotes from insurance companies by providing the information shown in the following form to any insurance company that sells annuities.

With fixed annuities, the insurance company accepts the mortality risk, the expense risk, and the interest risk and you accept the purchasing power risk. This is the ongoing risk that in spite of the fact that the dollar amount of your annuity check remains the same, the goods and services you can buy with that check diminishes over time.

A variable or equity annuity, is one in which the periodic payments received from the contract vary with the investment experience of the underlying investment vehicle. The variable immediate annuity was developed to answer the problem conventional fixed annuities have with inflation. The purchasing power of a conventional payment fixed annuity is eroded by inflation. It was hoped that the variable annuity, with a fluctuating income based on its underlying equity accounts, would adjust itself to current purchasing power. The variable immediate annuity can accomplish this objective, but not without risk to the annuitant. The risk is that the payments can decrease as well as increase. Keep in mind that once you annuitize, there is no turning back. You are not able to change investment accounts (an option available in deferred annuities) if you do not like the performance of the one you are in. There are no 1035 tax-free exchanges once you have annuitized. In short, you are stuck for life. So choose carefully!

2. History of the variable immediate annuity

The Teacher’s Insurance and Annuity Association (TIAA) and the College Retirement Equities Fund (CREF) are "non-profit" organizations providing insurance and annuities to academic personnel. These organizations did a great deal to develop the concept of the variable annuity and were the original source of such contracts. They fought the original regulatory battles, starting in 1952. In 1959, the variable annuity contract became subject to dual supervision by the Securities and Exchange Commission and the various state insurance departments.

The investment vehicle in a variable immediate annuity has to be a property that is easy to purchase, easy to sell, and moves with the economy, reflecting the general economic trend on a long-term basis. TIAA’s extensive studies covering common stock history from 1880 to 1952 showed that common stock was the closest to the ideal investment vehicle. More recent studies confirm this conclusion.

A Variable Immediate Annuity in Action

In an actual case, Aunt Gen deposited $15,288.80 on March 14, 1972, with an insurance company. She was guaranteed a monthly income starting at $100 per month, based on the number of units she purchased with her $15,288.80. As those units varied in value, so did her monthly income. As a result of the performance of the stock market and the underlying investment account of her annuity, the monthly payments dipped to a low of $63 in 1975. By the time the last payment was made in October 1986, the monthly payment was up to $234 per month. An ironic twist of this particular variable annuity was that by the time the 1980s arrived, and the monthly payments were consistently over $100 per month, most of Aunt Gen’s other assets had been used up. Her fear of running out of assets prior to her death was realized. Her annuity income and social security were about all that was available, and as a result she lived in low-income housing. Every time she received an increase in her monthly payment from the variable annuity, the low-income housing authorities raised her rent an equivalent amount. All she would have needed to complete the picture would have been the loss of her exclusion ratio and the increased taxation that Uncle Sam imposed on post-January 1, 1987, annuitants who manage to live long enough to receive a full return of basis.

3. Future of the variable immediate annuity

The current market for variable immediate annuities is small and there are relatively few sources of supply. The annuity payout principle appeals to conservative older individuals who have a substantial need for income and a desire to make sure that the income will not terminate during their lifetime. It is relatively unusual to find this same risk-averse individual willing to have funds paid out as a variable annuity because there is the potential for a decrease in income as well as the hoped-for reward of increased income.

The variable immediate annuity almost disappeared from the scene as a result of what happened to Aunt Gen and others like her. However, times are changing, and the risk of outliving one’s income and—more importantly—one’s purchasing power is increasing as more of us live into our 90s and beyond, well beyond the resources expected to be sufficient for retirement.

4. Variable immediate annuity strategies

a. All variable

b. Part variable, part fixed

c. Annuitize now and annuitize later

On one block of money take income now, possibly fixed period without life contingencies, and on another block of capital, a plan for a variable-based annuity income later. Specimen question: "If you knew that you were to live to age 85 and you were to have an income of $ ________ [whatever is a more than adequate amount for the individual you are questioning], what would you do differently now?"

III. Deferred Annuities Design Characteristics

A. Basic Distinctions between Fixed and Variable Annuities

You may be a purchaser of a deferred annuity and not be the least bit concerned with "annuitizing" your annuity, that is, changing your deferred annuity into an immediate annuity. Your primary concern may be to accumulate as much wealth as possible within the contract. Because the inside buildup of the annuity is not subject to current taxation when owned by an individual, your returns within the contract are not diminished by income taxes and can build up faster than taxable investments, which is the key to the deferred annuity’s appeal.

B. Characteristics of Deferred Annuities

1. Tax-deferred growth

Deferred taxation on the interest, dividends, and gains in market value until withdrawal, at which time ordinary income tax will be due on all earnings. This is identical to the benefits of the non-deductible IRA, which means that you can avoid all the restrictions and limitations of non-deductible IRAs by using a non-qualified annuity.

2. Flexibility

All of the "immediate" annuity payout options previously discussed are available to you with the accumulation in your deferred annuity, including the right to make tax-free exchanges from one annuity contract to another. You may also make a tax-free exchange from a life insurance policy into an annuity, but you may not tax-free exchange from an annuity to a life insurance policy.

3. Safety

The original invested capital is guaranteed by the insurance company offering the annuity. Pick carefully! When you annuitize, the income stream is guaranteed by the insurance company. It is guaranteed to be level in a fixed annuity, and guaranteed to fluctuate in a variable annuity.

4. Liquidity/marketability

You may recover the capital invested in an annuity subject to insurance company back-end loads, current taxation on interest earnings in the contract and a 10% penalty if you are less than 59-1/2 years old. If it is a variable annuity, it is also subject to the principal risk of the accounts to which you have directed your funds.

a. Liquidity inhibitors

i. Surrender charges, contingent deferred sales charges and/or early withdrawal charges

ii. Income taxes

iii. Pre-age 59-l/2 IRS penalties

b. Liquidity facilitators

i. 10% free corridors

ii. 30-day windows

iii. Withdrawal of earnings—interest or appreciation

iv. Death, disability and long-term care withdrawals

v. Market value adjustments

C. Deferred Annuities—Choosing between Fixed and Variable

Fixed annuities are debt investments—you are a lender of money to an insurance company. Your only return is the interest they pay you on the money lent. It is a "single-pocket" investment, that is, you are given no other investment alternatives within the annuity contract. The only alternative you have to accepting the interest offered by the insurance company is to terminate or 1035 tax-free exchange the contract and pay whatever surrender charges may be applicable at the time.

A variable annuity, on the other hand, is a "multiple-pocket" investment. It offers you an array of choices within which to invest your annuity capital. In many variable annuities, you will have a "fixed annuity" choice so that you can have all or many of the fixed annuity features and at the same time retain the flexibility to use any of the other investment options offered within the contract. The contract contains "interior competition," that is, the guaranteed interest account must compete with the other accounts for money. This may give the policyowner a more fair shake on interest crediting than is given by single-pocket contracts, in which you either accept the interest offered by the contract or get out.

D. Accumulation Units vs. Mutual Fund Shares

When you buy into a deferred variable annuity, the purchase of the accumulation unit is similar to the purchase of a share in a mutual fund. Your money arrives at the insurance company and the company calculates the value of the account accumulation unit at the "closing price" the day the money is received or the next business day on the New York Stock Exchange. Your money purchases units of the fund based on that unit value. This procedure is referred to as "forward pricing" to distinguish it from the way stock is purchased (based on a quoted price prior to the receipt of payment).

There is also a difference in the way capital gains and dividends are treated.

With a share system, the receipt of periodic dividends and capital gains forces up share value until they are paid out in compliance with the Investment Company Act of 1940, which requires mutual funds to pay out 95% of dividends and capital gains, after which time share value goes down and additional shares are purchased with the dividend and capital gains proceeds.

Unit pricing sets the number of units, and the number of units changes only when additional money is invested. Unit values increase when capital gains, interest, or dividends are received within the separate account. The insurance company is not forced to distribute dividends and capital gains.

E. Deferred Annuities Categorized by Premium Payment

Deferred annuities come in all varieties. There are single premium deferred annuities, scheduled premium deferred annuities (the contract states how much and how often you must pay premiums), and flexible premium annuities.

1. Scheduled premium deferred annuities

The old-fashioned scheduled premium contract, which required a stated premium at stated times, has fallen out of favor. Its mandatory nature, loads, and penalties for not maintaining payments are unappealing.

2. Single premium deferred annuities

Single premium deferred annuities, although marketable and popular, have an unappealing lack of flexibility. There is market appeal for the concept of "single" premium (i.e., no additional payments being required); therefore marketing departments have been promoting single premium annuities that "can accept" additional premiums (non-single premium, single premiums!!). This may be a new definition of "market driven."

It is within the single premium, interest-only, deferred annuity variety that you find much of the competition and much of the publicity regarding annuity contracts. They appeal to the individual with a lump sum of capital available at a specific time who is seeking the highest possible interest rate. Buyers are often comparing the single premium, interest-only, deferred annuity vehicle to certificates of deposit. The insurance companies compete vigorously for this single premium investment.

3. Flexible premium deferred annuities

In today’s marketplace, annuity contracts with the greatest appeal give the annuitant the option of making payments when convenient and in amounts determined by the annuitant— in other words, flexible premium deferred annuities.

a. The importance of flexibility

These contracts are recommended because they give you the option of making payments when convenient and in amounts that you determine. Flexible premium deferred variable annuities can offer you many different types of investment accounts. They can have investment accounts that guarantee principal and interest similar to a fixed annuity, while offering you the flexibility of adding to that account in the future if you want to do so. In other words, you could have your flexible premium variable annuity emulate a single premium fixed annuity by directing your investment to a guaranteed interest account within the variable annuity and choosing to make only a single payment. In most cases, the variable contract with flexible premium options offers you greater opportunity to adjust the contract to changing future needs.

b. Flexible investment options

Flexible premium, deferred variable annuities also offer various investment funds that range from common stock accounts of the aggressive, blue-chip, and balanced varieties, to bond funds, zero-coupon, Ginnie Mae, and real estate accounts. You have the option of moving among these funds, switching your contributions and accumulations from one fund to the other, and managing the fund in accordance with your particular objectives.

4. Restrictions on flexibility

However, these accounts may contain restrictions on your ability to move funds, such as limitations on the number of moves you can make during a particular time period or charges for making moves from one account to another. Therefore, when you are selecting a contract, you’ll want to investigate the variety of funds available, charges for and limitations on movements from fund to fund, the quality of reporting, and the ease, convenience, and promptness of making moves. A telephone call is the easiest way to move account funds.

5. Special investment features

More and more funds are offering the convenience and the investment advantage of "dollar-cost averaging" services, whereby you instruct them to move money for you each month from one account to another. People who fear the stock market love the ability to put their money into a guaranteed interest account and then just move their interest into the stock accounts each month. This strategy ensures they will have no loss to their principal investment and can also participate in stock market gains. Since a variable annuity is similar to mutual fund investing, you also will be interested in the performance of the investment divisions and their management.

IV. Deferred Fixed Annuities

A. Interest Rate Considerations

Policyowners complain that insurance companies react slowly to rising interest rates, but those same policyowners seem not to notice when interest rate reductions lag the market on the way down.

Reducing interest rate environment: Insurance companies adjust to lower rates and have profits in their bond account.

Increasing interest rate environment: Insurance companies may pay more out than they are earning on their old investments and experience losses in the bond account. This disintermediation problem affects all companies whose business is based upon "the spread."

Insurance companies’ ability to invest in higher-yielding, higher-risk assets is limited by the regulators, the rating agencies, and public perception. Each of the factors have increased dramatically in importance in recent years and very likely will reduce the interest rates insurance companies are able to pay to policyowners for years to come.

1. Portfolio rate

Pure portfolio rate would mean all contract owners get the same interest rate minus the spread, and it ignores the fact that money coming in at different times is invested at different interest rates. It homogenizes the portfolio. It offers an advantage to new contract purchasers over all contract owners in periods of decreasing interest rates. In periods of increasing interest rates, the portfolio rate lags new money rates.

2. New money rate

The new money rate reflects the interest rate the money could be invested at when the money came into the insurance company minus the spread. In periods of increasing interest rates, the new money rate will allow the insurance company to credit higher interest rates than it could using the portfolio rate.

3. Bonus rate

Enhanced first-year interest rate. Avoid teaser, "come on," or "bait and switch" pricing.

4. Two-tier rate

You get a higher rate if you annuitize at the end, or a lower rate if you surrender or make withdrawals from the contract. Also, you get a retroactively lower rate from contract inception if you do not annuitize, as much as 2% less in some companies. This acts like a dramatically increasing surrender charge over the life of the contract. It has been another source of policyowner disappointment in the insurance industry, like with some school teachers who signed up for 403(b) plans in their 30s who find out what the provisions mean in their 60s when they are ready to retire.

B. Traditional vs. Modern Fixed Deferred Annuities

1. One-year adjustable interest rate with 5-to-10 year surrender charge

2. CD or certificate annuities

These annuities match the interest rate guarantee to the surrender charge period and have gained popularity with buyers because they contain no surprises and are easy to explain and understand.

3. Series of zeroes annuities

4. Market value adjusted annuities

Allow the insurance company to pay higher interest rates because if interest rates go up, instead of the insurance company accepting the loss if the client surrenders, the client accepts a market value adjustment and suffers the loss—a way of shifting interest rate risk to the client.

5. Buy, hold, annuitize…past history

Today annuities often are used as a rainy day stockpile of money that can be easily accessed, usually by periodic withdrawals, putting the policyowner in the position of being able to plan withdrawals in a way that minimizes income taxes.

C. Insurance Company Risks

1. Credit (bond default) risk

2. Rising interest rate risk

3. Industry and business risk

4. Single investment choice risk

5. General vs. separate account risk

V. Deferred Variable Annuities

A. Investment Vehicle

These are annuities in which the rate of return varies with the performance of the portfolio selected by the contract owner. The contract owner bears the market risk. Principal is guaranteed by the insurance company upon the death of the contract owner (death benefit guarantee) and in the guaranteed interest, guaranteed principal account option offered in most contracts.

1. Accumulation units vs. mutual fund shares

2. Investment options

B. Advantages of Deferred Variable Annuities

1. Flexibility

a. Greatest opportunity to adjust to change

b. Can emulate a single premium fixed annuity

2. Professional management

3. Investment diversification

4. General account and separate accounts similar to, but not the same as, or clones of mutual funds

Morningstar publishes its Variable Annuity/Life Sourcebook annually and will give you information about the performance, features, and expenses of variable annuities (800-876-5005). You also could find an advisor who has the Morningstar data on disk so they can help you search the marketplace for a variable annuity with acceptable costs, fund diversity and good performance.

5. Payout options

6. Income tax control

a. No income or capital gains tax when accounts within the contract are sold (re-balancing, asset allocation)

b. Control over when to pay income taxes because you control distributions

When evaluating a variable annuity, keep in mind that your objective is long-term investment growth for your retirement. You have chosen the annuity in order to increase capital faster since income taxation on interest, dividends, and—often most importantly—capital gains are deferred until you start using your money. Avoiding taxation on profits as you sell out of very profitable accounts and move to less volatile accounts in order to safeguard your gains is very important for two reasons. First, hopefully they will provide a good percentage of your return and exceed the amount you will earn from interest and dividends. Second, if you have ever owned a stock or mutual fund that had increased substantially in value…what would keep you from selling it? Either you think it is going to go higher or you don’t want to sell and give about one-third of your profits to Uncle Sam. If you hesitated and did not sell an investment like this in September of 1987, just before the 500-point drop in the Dow Jones average (October 19, 1987), you know how unwise it can be to let taxation drive your investment decisions. Investments inside of variable annuities are not subject to taxation, and so that consideration can be removed from your investment decisions within an annuity. Selling various sub-accounts and buying into others without taxation or transaction costs is one of the most profitable of annuity features. As a result, you want sub-accounts or mutual funds within your variable annuity than can accommodate your investment needs over a lifetime and that are profitably managed.

7. Convenience features

a. Dollar-cost averaging

A safe haven account is an account, other than a money market account, where contract holders can escape from volatility and earn a reasonable return. The guaranteed interest, guaranteed principal insurance company general account is subject to the creditors of the insurance company, so two things become important: the quality of the company, and the ability to move money out of the guaranteed interest account into the separate accounts (which are not subject to the creditors of the company).

10. "Package" format

11. Systematic withdrawals

12. Automatic minimum distribution from qualified annuities for those over age 70-1/2

13. Passes to heirs via beneficiary provision rather than probate with a guaranteed death benefit

VI. Consumer Issues

A. Regulation

Subject to the Securities Act of 1933 and the Investment Company Act of 1940. Sold by prospectus by a Series 6 licensed registered representative properly licensed with the state insurance department. Dual regulation by SEC and state increases cost.

The prospectus is required and can be a very positive and effective selling tool. Not using it or disparaging its use exposes the sales person to personal liability if the contract owner liquidates at a loss.

B. Company Safety

1. General account risks

From 1979 to 1983, the Baldwin United Companies of National Investors and University Life sold over 3 billion fixed annuities. They were touted as risk-free, promising interest rates of up to 15% plus commissions to agents of 5%. They then invested the money in the stock of their own subsidiaries. In May 1983, the Arkansas and Indiana Insurance commissioners put the companies into receivership. For over 3-l/2 years, it dragged through the courts while policyowners suffered. Some people, who really do not understand, say the policyowners were made whole when Metropolitan Life assumed the contracts. This is considered by some as the beginning of the end of insurance company credibility.

Executive Life started in 1980–81 to buy up high-yield (junk) bonds so that, of the $16 billion in Fred Carr’s Executive Life portfolio, more than 50% was in junk bonds. By 1990, when Executive Life was put into receivership, the assets were down to $10 billion and its highly touted $2 billion dollar cash reserve had flown out the door in the run on the company.

The saga continues with Mutual Benefit Life, Capital Life, Confederation Life, and too many others.

2. Rating services

a. A.M. Best

b. S & P

c. Moody’s

d. Duff and Phelps

e. Weiss

3. Risk-based capital and the NAIC

4. Legal reserve

A voluntary plan in which the insurance company adds between three to five cents for every dollar you put into an annuity

C. State Guarantee Associations

In all 50 states—intended to inspire confidence. The typical guarantee covers up to $100,000 in annuity benefits and $300,000 in all lines (life, health and annuities). Annuities are not actually guaranteed by the state, and in many states it is against the law for an agent to even mention the guarantee association. In others, agents must get a signed statement at the time of application that the purchaser understands that the annuity is not backed by the "full faith and credit" of the state. There is no state money in state guarantee associations to serve as a guarantee of annuity benefits.

D. Expenses

1. Spread

The fixed annuity "spread" is made up of sales and administrative costs plus profits. However, other fixed-dollar deferred annuity costs come in the form of:

2. Annual fees

An annual fee or contract maintenance charge of $15 to $50 is often charged against relatively small accounts and waived for larger accounts.

3. Surrender charges

a. Fixed period commencing with contract register date

b. Rolling for a certain number of years after each deposit

4. State premium taxes

a. At contract beginning

b. At annuitization

Watch for annuity state premium taxes in…

A Lipper study of returns of the entire universe of mutual funds and variable annuities concluded that mutual funds typically outperform variable annuities by 70 basis points. Do the features that make you less likely to redeem an annuity than your mutual funds allow the managers to invest in a fashion that allows them to make up some of the M & E costs?

6. Separate account expenses

You can see from these charges that bond funds within a high-expense variable annuity will not be able to do much for you since their long-term rate of return is about equal to the expenses. It is important to be aware of these expenses as you invest in these products. You are looking for an acceptable net after expense rate of return. If you have a general account investment within your variable annuity, the interest quoted normally is net (rather than gross, from which you would have to deduct these charges).

7. Front-end charges and rolling back-end loads

Amounts in excess of the free corridor amount would be subject to proportional surrender charges. Since most of these are flexible premium contracts, you may have "rolling surrender charges," which just means that each investment within the contract must stay within it for a certain period of time (e.g., 5 years) before the surrender charge is lifted from that block of money.

9. Commissions

E. Checklist for Evaluating an Annuity Purchase

1. Company

The financial strength and track record of the insurance company issuing the contract is of paramount importance in today’s financial world. An annuity contract is only successful when the relationship is long-term, i.e., lifetime.

2. Investment

Current interest rate if you choose a fixed annuity;.investment accounts, investment management, and competitive current interest and guaranteed principal accounts if you are choosing a variable annuity

3. Track record

Interest rate track record for fixed annuities; investment accounts track records and interest rate track records for variable annuities

4. Guarantee period

For the guaranteed interest rate

5. Minimum guaranteed rate

Of interest after the initial guarantee period is completed

6. Bail-out

Provisions that allow you to surrender the annuity contract without penalty if the interest rate falls below a contractually stated amount

7. Cost of bail-out

That is, do you have the option of accepting higher interest and no bail-out provision, or lower initial interest with a bail-out provision?

8. Withdrawal privilege

Free withdrawal privilege—how much cash can you withdraw from a contract each year without being subject to insurance company-imposed withdrawal charges? Withdrawal from any annuity before age 59-1/2 would be subject to a 10% penalty and income taxes to the extent of gain.

9. Front-end charges

Sales charges applied against and thereby reducing your initial deposit

10. Surrender charges (back-end charges)

What percentage of the annuity would be left with the insurance company to cover deferred sales charges if you surrendered the annuity, and at what point would such surrender charges no longer exist?

11. Waiver of surrender charges

Under what circumstances are the surrender charges waived, such as death, disability, or an annuity payout?

12. Withdrawals not subject to surrender charges

Often referred to as the "free corridor." Most annuities allow you to withdraw 10% of your annuity value without the imposition of surrender charges.

13. Market value adjustment

Is there market value adjustment? That is, if the annuity contract is surrendered, is the surrender value adjusted as a result of changes in prevailing interest rates? This would be typical of a variable annuity bond account. It is found in some "fixed" annuities, and it can be one of those unpleasant surprises for a contract owner long after they have forgotten that it existed (assuming they were told). These market value adjustments expose registered reps, companies, and the industry to criticism, and you may wish to avoid them.

14. Death benefit

If you surrender your fixed annuity, typically you will be exposed to a surrender charge or, in some cases, a market value adjustment. At death, what would be the situation for your named beneficiary? The death benefit provision eliminates these charges if the contract termination is as a result of death. The cost of this provision is factored into the interest rate the insurance company pays you. It is in the "spread." With variable annuities, a significant drop in the stock market could expose you to significant principal risk. To protect against this risk, you will find that with most variable annuities, the beneficiary will receive the annuity at market value or the owner’s investments in the contract, whichever is greater. You can expect to find approximately a 0.5% charge for this type of guarantee, which you should find explained within the prospectus for the variable annuity.

In order to reduce the insurance company’s exposure to the risk, they will (1) limit the ages at which a deferred annuity can be purchased, (2) require annuitization in some cases, and (3) reduce commissions on contracts sold to older people.

15. Annual fees

Are there any annual fees?

16. Commissions

What is the commission, what services does it buy the consumer, and what is its effect on the consumer’s account value?

VII. Annuity Taxation: Applicable Laws

A. General

1. Fixed annuity

Income tax treatment of annuities is governed by Internal Revenue Code Section 72. Amounts received under an annuity contract are includible in income except to the extent they represent a return of the investment in the contract.

If payments are to continue for a life or lives, expected return is arrived at by multiplying the sum of one year’s annuity payments by the life expectancy of the measuring life or lives. The life expectancy multiple or multiples must be taken from the annuity tables prescribed by the IRS—IRC Sec. 72(c)(3). The result is a percentage of income, which is the return of basis each year until all basis is recovered (exclusion ratio).

2. Variable immediate annuity

In a variable immediate annuity, expected return is unknown, so instead of calculating expected total return, we calculate the time period (life expectancy) over which we expect to recover the investment or cost basis in the contract. That amount is excluded from taxation each year until all basis is recovered.

General Taxation of Annuities

2. It created a 5% government penalty for pre-age 59-1/2 withdrawal, which reinforced the idea that annuities were a long-term hold. This penalty could be avoided by annuitizing for at least a 5-year time period.

Those who had an annuity from prior to August 14, 1982, were "grandfathered" to the old rules.

These new rules forced new buyers to take a serious look at why they purchased an annuity.

C. DEFRA

The Deficit Reduction Act became effective January 18, 1985. It closed a significant loophole in annuity taxation. Prior to DEFRA, the annuity paid out only when the annuitant died. It created the opportunity for a grandfather to own an annuity and name his granddaughter as the annuitant. When the grandfather died, his son would become the new owner of the contract and would continue the tax deferral.

1. After DEFRA, the contract was required to be paid out at the death of either the owner or annuitant. Now if the grandfather owns an annuity and names his granddaughter as the annuitant and the grandfather dies, the money goes to the beneficiary.

2. DEFRA created the spousal exemption. The spouse of the deceased owner/annuitant may continue the contract and the deferral. This rule is why almost all annuities are structured to have one spouse as the owner and annuitant, with the other spouse as the beneficiary.

D. Tax Reform Act of 1986—Effect on Annuities

The general rule has been that the annuity earnings accumulate within the annuity to a tax-deferred basis.

1. Non-natural person rule

TRA ‘86 modified the general rule so that only an annuity that is owned by a natural person will enjoy this tax-deferred income. Code Sections 72(u) and 71(q) provide that an annuity contract issued or added to after February 28, 1986, owned by a corporation, partnership, or other non-natural person will not enjoy the tax-deferral on the inside buildup. Taxes will have to be paid each year on contract earnings. Contracts contributed to by February 28, 1986, have been grandfathered and will not be taxed on prior or continued earnings on such contributions.

In order to determine the way funds will be taxed when distributed from tax-deferred annuities, we have to look to the date that the funds were put into the annuity. If the funds were received into the annuity by August 14, 1982, withdrawals from the annuity will be received by the annuitant as principle first and income second (first in, first out—FIFO). If a contract received deposits after August 14, 1982, withdrawals are taxed as income first and principal last, to the extent of earnings in the contract (last in, first out—LIFO). The annuitant is exposed to ordinary income tax immediately on withdrawals from such contracts. The ordinary income tax liability is created when a partial withdrawal or lump-sum distribution is made. If the annuity contract is pledged or assigned as collateral for a loan, ordinary income taxes are due on the amount collateralized up to the amount of the accumulated earnings in the pledged contract and the 10% penalty applies if prior to the annuitant’s age 59-1/2.

2. Changed the pre-age 59-1/2 penalty from 5% to 10%

TRA ‘86 also increased the penalty tax from 5% to 10% on withdrawals prior to age 59-1/2 from both non-qualified and qualified deferred annuities. The penalty tax is waived if the owner of the annuity is age 59-1/2 or older, dies, or becomes disabled; or if the annuity contract is being used relative to the periodic payments required under a personal injury suit. The penalty also will be waived if benefits are annitized, paid out in a series of substantially equal payments over the life of the annuitant, or over the joint life of the annuitant and the primary beneficiary. This 10% penalty tax also is applicable to withdrawals from pre-August 14, 1982, annuities. These contracts were grandfathered from the standpoint that you may still consider withdrawals to be of principal first and thus not subject to tax up to the pre-August 14, 1982, cost basis. However, you will now have to pay the 10% penalty tax to take taxable funds out prior to age 59-1/2. Once your pre-August 14, 1982, basis has been recovered without taxation, your next withdrawals will be entirely taxable annuity earnings and thus also subject to the 10% pre-age 59-1/2 penalty.

The Tax Reform Act of 1986 set in motion the current popularity of annuities, even though restrictions on annuities became more onerous.

Even though these new restrictions on annuities were harsh, what was done to other investment areas was even more harsh. TRA ‘86 made it harder for municipalities to issue tax-free bonds. The shrinking supply caused yields to go down. In addition, there was no incentive for investors to hold stocks for more than one year to get a capital gains tax cut. Annuities retained the power of tax-deferral, and that was all that mattered.

E. TAMRA

The TAMRA Act of 1988 tightened rules even more. It created the aggregation rule. If a person buys more than one annuity from the same company within the same calendar year, when one is surrendered, the interest on the other must also be realized as well.

Prior to the aggregation rule, if you wanted to invest $100,000 in an annuity, it would be recommended that you submit four applications of $25,000 each to the insurance company. Later, when the $100,000 had grown to $150,000, you did not have one $50,000 gain. Instead, you had a $12,500 gain in each contract. One of the contracts could be surrendered for $37,500 and only $12,500 would be taxable.

Under the aggregation rule, purchases had to be aggregated so that if one of the contracts was surrendered for $37,500, the entire amount of gain in all contracts purchased in the same year from that one company would be taxable. Then the cost basis in the contracts would have to be adjusted.

This is a complicated rule, which has led to misinterpretations. In fact, some interpreted it to apply to all annuities purchased in the same year regardless of the number of companies involved. The complexity of the rule and the difficulty in explaining it made the idea of systematic withdrawal sound simple and appealing.

F. Annuity Contract—Pre-age 59-1/2 Taxation and Penalties

You might as well consider pre-age 59-1/2 annuity accumulation and liquidity as a contradiction in terms. There are three reductions in value that your annuity can be exposed to should you decide to take money out of a post-TEFRA deferred annuity (issued after August 13, 1982). First, there can be charges from the insurance company that issued the contract. Many annuity contracts are back-end loaded. They make little or no up-front charges when you deposit money into the contract, but they do make charges for premature withdrawals, referred to as back-end loads. These charges usually disappear after 5 or 10 years. However, you also have to be careful because some companies have what are referred to as rolling back-end loads, which means that when new money is put into the contract, the time period for the back-end load for those funds starts all over again on the day of the deposit.

In addition to the charges made by the insurance company, there are two potential charges from Uncle Sam. The first is ordinary income tax on the amount of money withdrawn from the annuity contract to the extent that there are earnings within the contract. It is not until all of the interest earnings on your annuity contract have been removed and subject to taxation that your principal will come out without further taxation (applied to post-August 13, 1982, contracts).

In addition to the income tax, there will be the excise tax. There is a 10% tax penalty for making withdrawals from your annuity contract prior to age 59-1/2. It is the annuity contract owner’s age, not the annuitant’s age, that determines if the pre-age 59-1/2 penalty applies; it is the owner who is taxed on all distributions, not the annuitant.

Withdrawals from annuities purchased before August 14, 1982, are considered to be all principal first and interest earnings after all principal has been withdrawn. Therefore, withdrawals from such annuities up to the contract owner’s basis escape current income taxation. However, pre-age 59-1/2 withdrawals of these pre-TEFRA annuities do not escape the 10% excise tax if the withdrawal is taxable earnings. After 59-1/2 years of age, you can eliminate this penalty tax from consideration.

G. Avoiding IRS Penalties on Income from Annuity Contracts prior to Age 59-1/2

1. Separation from service after age 55 allows access to corporate retirement plan capital without 10% pre-age 59-1/2 penalties.

2. Income distributions normally subject to the 10% penalty can avoid it by complying with the Code Section 72(t)(2)(A)(iv) rules regarding equal periodic payments based upon a mortality table and reasonable interest rates. "Annuity" payments must continue at least 5 years and beyond age 59-1/2, whichever is longer.

VIII. Special Taxation Issues

A. Qualified vs. Non-qualified Annuities

Non-qualified annuities refers to those annuities that you invest in individually, without the tax advantages of one of Uncle Sam’s formal retirement plans (such as those provided through your employer or qualified IRA). The premium payments into a non-qualified annuity are non-deductible. If the premium payer and the contract owner are the same individual, the assets of the annuity are part of the estate of the contract owner for estate tax purposes.

Contributions to qualified annuities are tax deductible to the extent that the annuitant qualifies to participate in such plans. There are times when you may continue to make contributions to a qualified annuity even though you do not qualify for deductible contributions. Your income may be too high for a deductible IRA contribution and/or either you or your spouse are already participating in an employer-sponsored plan.

1. Qualified annuities are found in:

a. IRAs

b. SEP IRAs

c. Tax-sheltered annuities, teacher annuities, 403(b) plans

d. HR-10, Keogh plans

e. Pensions

f. Profit-sharing plans

g. 401(k) plans

2. A Tax Shelter Inside a Tax Shelter?

Why would you put something tax-deferred into something that is tax-deferred?

Because I need safety, security, growth, and annuitization. I have ruled out stocks, bonds, CDs, and fixed annuities and am left to consider mutual funds and variable annuities.

The answer to that question is that many people find the existence of a guaranteed interest, guaranteed principal account—uniquely found within insurance company annuity contracts and not available in mutual funds—to be an important feature to them in the management of what is often their most important and sizable block of money. This is money that may have taken a lifetime to accumulate. It often was available within the guaranteed interest account of their employer’s plan so, in spite of the fact that diversification and the prudent use of equities should be a part of their retirement investments, they wish to avoid any volatility with their "important money." Certainly, they could use the money market fund within a mutual fund family for this money, but they view the returns as inadequate, and the stock and bond market of 1994 has proved to them that the guaranteed interest contract (GIC) is the only thing they can rely on. The variable deferred annuity under these circumstances becomes the product of choice. This is assuming contingent deferred sales charges are not a problem, and that the insurance company is investment grade and also allows the contract owner sufficient flexibility to exit the general account (GIC) if solvency ever becomes a concern.

The typical variable annuity then has features to help the client wean themselves from dependence on the GIC by dollar-cost averaging the interest earnings into the equity accounts. In this way, the account value will never be less than the beginning balance, and yet the prudent use of equities can be taught in a manner that allows the client to sleep comfortably. The volatile, go-no-place 1994 market was perfect for this strategy. The intermediary’s most important job may be to shepherd people through the hard times so that they have some part of their assets in equities for the good times that may take years to come but, as history has proven, eventually do come. Think what a hero the intermediary would be who shepherded a client through a dollar-cost averaging strategy in equities from 1972 through 1979, one of the longest periods the stock market has ever stayed in the doldrums. When success eventually comes, the equities can be sold and the cash returned to the GIC account, where more interest is generated to continue the dollar-cost averaging back into the equity accounts. Once a client experiences success in investing in equities, fear usually diminishes and, over time, a more reasonable asset allocation strategy may be put in place. Is this "right" for a person who needs these features in spite of the fact that the average expenses in the separate account of annuity contracts may exceed the average expenses in a mutual fund by 1%? Many advisors in the public press feel that it isn’t because they make their decisions based solely on expenses, but it is the right decision for many who are comfortable with this type of investment and find it easy and convenient to manage. It is this type of investor who earns the best returns—one who is comfortable, knowledgeable, and understanding. Fear and irrational moves reduce returns. This type of vehicle helps them do what they could not do in mutual funds. The extra cost in the separate accounts gives them the features that allow these people to earn more than they could otherwise.

3. The qualified plan advantage

A $1,000 investment (costing only $700) has resulted in $1,300 being added to the employee’s investment account. This is a gain of $600 over the employee’s $700 cost of investment, an 85.7% gain. How much would this employee have had to make in order to add $1,300 to his own account with after-tax dollars?

Take the amount to be deposited ($1,300), and divide by one minus the tax bracket
(1 – .30). Therefore the earnings required to make this investment on an after-tax basis would be $1,857.14. To check this, merely apply the 30% tax bracket to these funds ($1,857.14 x 30%) to find that the tax would be $557.14, leaving $1,300 to invest. That is 2.57 times what it cost through the IBM plan.

Qualified plans offer such an advantage that you should participate whenever practical to the maximum extent possible.

Annuity contracts, qualified or non-qualified, offer outstanding investment and wealth-building opportunities. Tax-deferred compounding is a powerful tool. Tax-deferred compounding throughout two lives, both husband and wife, is even more powerful. There are no computations, no reporting, and no current dividends, interest, or gains to keep track of or report. Opportunities to change your investment orientation without current taxation are available, as is the opportunity to control your future taxation by controlling payouts from your contracts.

Non-qualified IRA contributions have the same limitations as qualified IRA contributions—$2,000 per year ($2,250 with a non-working spouse).

4. The dilemma of non-deductible IRA contributions

Non-deductible IRA contributions create a tax-reporting and record-keeping requirement that goes on for the rest of your life. You must be able to establish the portion of the funds put into the IRA that qualify for a tax deduction and what funds do not. You even have to be able to do this at the time when you are ready to take the funds out at retirement. An exclusion ratio will be established when funds are taken out of the IRA that will reflect the non-deductible contributions made to the contract so that these funds may be excluded from taxation at distribution. To avoid the $2,000 limitation, the reporting requirement, and the record-keeping problems non-deductible IRAs could create, you could use an individually purchased, non-qualified deferred annuity contract. The taxation of the contract upon distribution would then stand on its own. This type of contract is not subject to the $2,000 per year limitation, the reporting requirement, or IRS record-keeping requirements.

The people in the press constantly advise you to continue non-deductible contributions to IRAs. They argue that you still receive the value of the tax-deferred earnings and that it is such a valuable wealth accumulation opportunity that you should not pass it up. All of this is true, but it does not address the fact that you can enjoy tax-deferred or even tax-free earnings from a number of other investments.

5. Taxation of non-qualified annuity income—the federal income tax exclusion ratio

These are after-tax investments in which your investment establishes a cost basis in the contract. The exclusion ratio calculation determines the amount of your annuity payment that is taxable earnings and how much is the non-taxable return on investment. This is a major difference between the non-qualified annuity and the qualified annuity. In the qualified plan, you have no cost basis because you have made no post-tax contributions into the contract. Therefore, when payout day comes, the tax liability is on the entire amount coming out of the qualified annuity.

When you purchase a non-qualified annuity, a greater portion of your annuity income is usable because part of your income is a return of capital and not taxable. This is recognized in the federal income tax exclusion ratio. The proportion of the annuity income that is tax-free is determined in accordance with Section 72 of the Internal Revenue Code.

The exclusion ratio is determined by dividing the investment in the contract by the expected return as of the annuity starting date, the day the income stream commences. You might invest $60,000 in an annuity and expect $100,000 as the payout. Therefore 60% of each payment would be a non-taxable return of capital while the balance would be taxable interest.

Investment of $60,000/Expected Return of $100,000 = 60% Exclusion Ratio

Exclusion Ratio x Payment Received = Amount Excluded from Taxation

60% x $1,000 = $600

You know the amount of the investment you have put into the contract. However, determining the expected return is complicated by the fact that no one knows how long you are going to live. If we assume that you’re not going to live very long, this would result in a greater portion of your payments being tax-free return of principal. You might be trying to prove to Uncle Sam how sick you are to minimize your income taxes.

In order to solve this problem, the IRS has provided four life expectancy tables in Internal Revenue Regulation Section 1.72. These are to be used in determining expected return. Exclusion ratios vary depending on the type of annuity purchased. The higher the guaranteed return of capital after the death of the annuitant, the lower the exclusion ratio. It will also vary based upon the age and sex of the annuitant.

The exclusion ratio results in a greater portion of your income stream being usable income, because it is not subject to current income taxes. A comparable stream of fully taxable income would result in increased taxes, thus reducing your spendable income.

6. Exclusion ratio—TRA ’86 change

We need to make one final point concerning the taxation of annuity income. The federal income tax exclusion ratio is one of the advantages of the annuity. In our example, it was approximately 60% of the annuity income. This exclusion ratio formerly applied throughout the annuitant’s lifetime. Therefore, even if you lived far beyond the time predicted in the life expectancy tables and had received all of your tax-free principal back, you continued to receive approximately 60 percent of your income without taxation throughout your lifetime. The Tax Reform Act of 1986 changed this situation for annuities not yet annuitized on January 1, 1987. Under that law, once the annuitant has received his investment back without taxation, the exclusion ratio will cease to apply. Payments continuing beyond that point will be taxed entirely as ordinary income. In our example, this would result in increased income tax for the annuitants at approximately age 85. This means that individuals who have lived on a level monthly income unadjusted for inflation for 20 years, who took the annuity because of their need for spendable income, will be blindsided by Uncle Sam with additional income tax at age 85. Do you suppose our politicians will use those additional tax dollars for the indigent elderly? The mothers of those politicians should know what they are doing to them!

7. Qualified plan annuity minimum distribution

By April 1 of the year following the year you attain age 70-1/2, you must take at least minimum annual distributions from your qualified plan, that is, such retirement plans as individual retirement accounts (IRAs) and SEP, profit-sharing, 401(k), and pension plans.

Most people choose to take their first minimum distribution in the year they attain age 70-1/2 rather than waiting until the first quarter of the following year. If you wait until the following year, you would have to take two minimum distributions, one for the year in which you were 70-1/2 and one for the year in which you were 71-1/2. This could stack too much income into that one year.

a. Single vs. joint life basis

When calculating the amount of your minimum annual distribution, you may choose to do it on a joint life basis with your beneficiary or just based upon your own single life. Choosing to do it on a joint basis will reduce the amount you have to take out because, as you will note in the tables, two 70 year-olds have a longer life expectancy (20.6 years) than one 70 year-old (16 years). So if slow withdrawal is your objective, allowing your money to continue to earn without current taxation, then using the joint life tables will work better for you. You are allowed a spread in ages of up to 10 years (Uncle Sam’s limit).

b. Annual reduction vs. annual recalculation method

There are also two different methods you can use to calculate each year’s withdrawal: the annual reduction method or the annual recalculation method.

i. Annual reduction method

Under this method, you reduce your life expectancy by 1 year each year. For example, if you started out using 20.6 years, the next year you would merely subtract 1 year and use that number as your divisor. You divide your retirement plan balances by your life expectancy. Specifically, your calculation in the year you attained age 70-1/2 would be as follows. Add up all of your qualified plan balances as of December 31 of the year prior to the year you became age 70-1/2. It certainly will simplify your life if you have consolidated all of those small IRA accounts and your qualified plan amounts into one place by this point in your life.

Divide the total of all retirement account balances by your life expectancy or joint life expectancy factor, whichever you have selected. If it happens to be 20.6, dividing by that number will tell you your minimum distribution requirement for that calendar year. It would be wise to take the distribution out during that calendar year, even in the first year, if you wish to avoid a double withdrawal in the following year. If you have chosen the annual reduction method, you will take the balance on the next December 31 and divide it by 19.6 to determine the minimum distribution requirement for the second year. Do likewise in each succeeding year (e.g., 18.6, 17.6, etc.)

ii. Annual recalculation method

With the recalculation method, you use the IRS table factor for your ages each year rather than just subtracting 1 year from the previous year’s life expectancy. Thus, instead of going from 20.6 to 19.6 as you do with the reduction method, you would go from 20.6 to 19.8 as indicated by the table for the life expectancy of two 71-year-olds. As you can see, this method reduces the amount you have to take out and thus allows you to leave more in your plans to continue to enjoy tax-deferred compounding.

However, there can be an income tax disadvantage in this recalculation method for those without a spouse beneficiary. If you die during the payout period, it affects how your beneficiaries are taxed. Uncle Sam in his infinite wisdom says that under the recalculation method, your life expectancy is now zero in the year after your death! Thus your spouse will have to do the recalculations on a single-life basis; this causes the distributions to be much larger than would have been the case had you selected the annual reduction method, which could be continued at the same pace after your death.

A non-spousal beneficiary must take total distribution and pay all income taxes due in that year—no more tax deferral for them! However, if you had chosen the annual reduction method, they could continue the payment schedule you had set up or take it faster (but not slower).

B. Taxation of Annuity Income

1. Social security benefits tax

The social security benefits tax came into being in 1985. Its intent is to tax the more affluent social security recipient. Originally it was possible for a person to pay taxes on up to 50% of social security benefits. A revision in the rule now makes it possible to pay tax on up to 85% of benefits.

A married couple who have paid in the maximum contribution over their lives have a social security income of about $14,000. This would mean an additional tax of about $3,330 if they are in the 28% tax bracket.

The calculation of this tax requires the inclusion of income from all sources, including tax-free municipal bonds. If the total income is over $44,000 for a married couple, then the tax is phased in. Therefore, even though municipal bonds are free of federal income tax, income from the bonds is added to other taxable income to determine if there is going to be tax due on social security benefits.

Annuities in the deferral stage and the part of an annuitization that is return of principal are not considered taxable income for this calculation.

2. Annuity income is all ordinary income.

3. Annuity "losses" that occur within the contract do not reduce income taxes. Losses (difference between cost basis and surrender value) that occur at surrender or company insolvency may be used.

C. Transfer of Ownership Issues

1. 1035 exchange

a. Rule of constructive receipt

The IRS allows for the tax-free exchange of many types of assets, annuities included. As you would expect, there are some very precise rules that govern exchanges. Violating those rules can result in taxable gains.

The main idea in completing a 1035 tax-free exchange is to not violate the rule of constructive receipt: If you have control of the money, even though it’s not in your bank account, the money is yours and the interest/gain is taxable. The issue is control of the money.

b. Rule 1035

Rule 1035 is the IRS rule that dictates how to go through the process of moving from one contract to another. The key to successfully completing a 1035 exchange is to have the old company send the money directly to the new company without having it go through the owner’s hands. This is done fairly simply by having the owner send a letter to the old company instructing them to send the new company a check payable to the new company, f.o.b. the owner annuitant.

If the check is made payable to the owner who then endorses it over to the new company, the rule of constructive receipt has been violated and the 1035 tax-free exchange will not be successful. Too often owners act without proper advice and surrender an annuity thinking that the reinvestment will work like an IRA rollover. Once they have the check in hand, they look for something to do with it only to discover that a taxable event has occurred.

c. Must be the entire balance

You may not take part of the annuity and exchange it. It is either all or none, with no exceptions.

d. 1035 limited application

The 1035 exchange rules apply to life insurance, endowment contracts, and annuities. There are some concrete rules to live by if you intend to effect a 1035 exchange. You may exchange:

i. Annuity to annuity

ii. Life insurance to annuity

iii. Endowment contract to annuity

An endowment contract matures, usually at age 65. It may be exchanged for an annuity any time prior to the maturity/endowment date. However, once converted to a deferred annuity, it must be annuitized no later than the date of the original contract.

iv. Life insurance to life insurance

2. Transfers of ownership as taxable events

TRA ‘86 Section 72(e)(4)(c) declared that a change in the ownership of an annuity is a taxable event that will be treated, for tax purposes, as if the annuitant had died. In short, it means that unless the recipient beneficiary is the annuitant’s spouse, the tax deferral cannot continue. In order to avoid this problem, do not make gifts of annuities or make cash gifts into annuities already owned by the individual to whom you wish to make the gift. In order to qualify for the $10,000 gift exclusion, the annuitant should have a present interest in the use and enjoyment of your gift.

3. Appropriate gift strategies

Anyone may make a gift into an annuity contract that someone else owns. If the recipient of this gift is a spouse, the gift will be sheltered from gift taxation by the unlimited marital deduction. Non-spousal gifts must be considered more carefully.

At the present time, each of us can give $10,000 per year to any individual and, if it is a bona fide gift and a gift of a "present interest," it will be exempt from gift taxation. If you join together with your spouse in making the gift to a third person, then $20,000 may be gifted without the imposition of gift taxes. This is commonly referred to as a "split gift." However, if you plan to use the shelter of the split gift, you will have to file a current gift tax form with the IRS.

In order to qualify for the annual $10,000 per individual gift tax exemption, the payment of the premium into the annuity contract must create a gift of a present interest for the contract owner (ability to control the benefits of the contract currently). If the gift of the premium into the annuity contract is deemed to be a gift of a "future interest" (enjoyment of contract benefits is deferred) and/or is in excess of $10,000, it will be subject to gift taxes. A gift tax return should be filed and, if the giver of the gift has used up his lifetime "unified credit" of $600,000 available under the unified transfer tax system, then gift taxes would be due as determined under the unified transfer tax rate schedule. Once an individual has used up the $600,000 exemption, additional gifts would be taxed at a rate starting at 37% and increasing to the top tax rate of 55%.

If a gift is being given for the payment of tuition or medical expenses, these gifts can qualify for an unlimited exclusion by complying with the regulations controlling such gifts. You might wish to utilize this special exclusion to make a gift. This would enable you to give a non-taxable gift that would not be drawn back into your estate for federal estate tax purposes. An annuity contract can be useful in providing for a non-spouse’s medical expenses, such as an aging parent’s nursing home expenses.

People often gift assets in order to pass the tax burden on to the recipient. The recipient isn’t bothered by it too much because he is better off net of tax than he was prior to the gift being given.

D. Annuity taxation at death

The taxation of annuity proceeds in the event of the death of the annuitant will depend upon two things: (1) whether income has or has not commenced at the death of the annuitant, and (2) whether the beneficiary receiving the proceeds of the annuity contract is the annuitant’s spouse.

1. Variables

a. Estate tax

The IRS is quite clear about the status of annuities with regard to estate tax. The entire value of the annuity is considered for the estate tax calculation.

b. After income has commenced

If the owner was receiving annuitization payments, the present value of any remaining payments would be included in the gross estate.

c. Spouse as beneficiary

Even if the spouse elects to continue the contract, the deferred annuity is a part of the estate, just like any stock or bond.

First, let us assume that payments had not yet begun at the annuitant’s death, leaving the proceeds of the annuity to the surviving spouse. The spouse has the option of continuing the annuity and enjoying the tax-deferred earnings or taking a distribution and paying the taxes. The spouse beneficiary will have to decide within 1 year which it will be because once the year runs out, the spouse must take out all the money and pay the taxes by the end of a 5-year time period.

However, if the annuitant had started to receive benefits and died leaving the annuity proceeds to the surviving spouse, the benefits would have to be distributed at least as rapidly as the method that was in effect at the time of the annuitant’s death. Taxation will continue to apply to those proceeds.

d. Whether owner and annuitant are the same

If a non-spousal beneficiary receives the proceeds in the event of the annuitant’s death prior to the distribution of any income, the non-spousal beneficiary may elect a lump-sum distribution without penalty but with full taxation on the accrued interest or gain within the contract. Alternatively, the annuitant may elect a series of payments to be made over a period of time not to exceed the beneficiary’s life expectancy, beginning within 1 year of the annuitant’s death. The non-spousal beneficiary has no option to continue the contract, and although the payment is not subject to a 10% penalty tax since it is the result of the annuitant’s death, it will be subject to ordinary income tax to the extent of the decedent’s earnings in the contract.

If the annuity income had started prior to the annuitant’s death, then the proceeds would have to continue to come out of the annuity at least as rapidly as the method that was in effect before the annuitant’s death, with normal taxation continuing.

The taxation of these benefits from non-qualified annuities will be based upon the exclusion ratio; that is, the investment in the vehicle will be divided by the expected return to determine the exclusion ratio. Each payment to be received by the beneficiary is multiplied by the exclusion ratio to determine the amount of the payment that would be excluded from current taxation as a return of principal, up to a point where basis has been fully recovered. After that, all payments are fully taxable as ordinary income.

2. Probate costs are avoided if the annuity is payable to a named beneficiary other than the estate.

3. Step-up in basis does not apply to annuity contracts.

4. The net benefits of annuities can be reduced by income taxes (federal, state, and local), estate taxes, and even excise taxes at death. Changes of ownership during life trigger income taxation on all annuity earnings; thus they are very difficult to get out of an estate owner’s estate. They are best used during the lives of the estate owner and spouse.

Suppose a mother wants to gift some stock to her daughter. If the mother bought the stock for $2 a share and at the time of the gift it was worth $10, the daughter would have the original $2 as the cost basis. If she later sold the stock for $12, she would pay tax on $10 per share. If the mother willed the stock to her daughter and the value at the mother’s death was $12, then the daughter would have a $12 cost basis.

If that same mother bought an annuity for $2,000 and later, when the value was $10,000, she gifted the annuity to her daughter, the mother would pay tax on the $8,000 gain. In addition, an annuity with a different owner and annuitant can cause problems at death.

Keep in mind that annuities are for retirement income designed to be used up during the owner’s and spouse’s lives. Annuities passing to non-spousal beneficiaries incur income taxes, whereas many other assets receive a step-up in cost basis at the death of the original owner and are thus forgiven income tax liabilities that the new owner would have incurred. The net benefit to beneficiaries of annuities can be reduced by income taxes, estate taxes, and even excise taxes at death, and thus are best used during the lives of the annuitants.

IX. Conclusion

During this century, average life expectancy has gone from 47 years to 77 years.